The Emperor’s New Clothes: How to Pay off the National Debt & Give a 28.5% Tax Cut

I offer a £1,000 reward for anyone who can tell me why this logically won’t work, practical politics, for now, being another matter.

What follows is an attempt to show you that this can be done.

Remember the story about the Emperor whose only concern was not the welfare of his people but the state of his clothes? Lacking a new outfit for his procession, he instructs the finest clothe-makers to propose designs. Step forward Slimus and Slick, promising that only clever people will be able to see their splendiferous garments; they will be invisible to anyone stupid. In exchange for gold coin – real money – they make something special for the King. The King, seeing nothing when presented with these designs made out of thin air, worries that he must be stupid because he pretended to the fraudsters that they were wonderful. Word goes round that only clever people can see the garments, so everyone cheers the naked King during his procession. It takes a small child, on top of his father’s shoulders, to exclaim: “the Emperor has got nothing on!” Everyone falls silent. Then, one by one, they start muttering, “the Emperor is naked!”

I am going to tell you that our Emperor – the government – has no clothes and is indeed naked with respect to our money. The sooner we realise this the better. Then we can make real progress and prevent the imminent misery. Indeed, the realisation of its nakedness should reveal that we have a unique moment in history to do something very special: to make banking secure, pay off the national debt, and even enable a 28.5% income-tax cut.

We all know what notes and coins are: money, or cash. It allows us to exchange the fruits of our work for the goods of others. When we deposit cash in Bank A – say £100 – we lend this money to the bank. This may come as a surprise to most, as we think what we deposit in a bank actually remains “ours” beyond this point. But as soon as you make a deposit it becomes the bank’s i.e. “theirs.” They then lend what is called credit of £100 to an entrepreneur, who banks it in bank B. Like magic, we now have you, who have a claim to “your” £100, and the entrepreneur, who also has an equally valid claim to “his” £100. This happens 33 times for every £100 deposited in the UK economy on average, meaning that for every £100 deposited, it is lent out to 33 people. Some of the banks did this up to 60 times. This cash cannot exist in two places at the same time, let alone 60 places at once. So what bank A does, is write you an IOU. Yes, your bank-statement is a mere IOU, the bank saying “ bank A owes you £100 on demand.” This is called a demand-deposit. We now see that demand-deposits are created out of thin air! Indeed, these are just ledger-entries from one bank customer to another.

Tesco groceries can be paid by electronic transfer. All we are doing is moving our bank’s IOU to Tesco’s bank in exchange for their groceries. This is how the world works. Do we care that we are buying goods and services out of thin air? Like the Emperor, does he care – as long as all believe he is clothed? Well, the customers of Northern Rock did. So when more than a small percentage of them asked for their IOUs from Northern Rock to be repaid – or, as they thought, for “their” money back – it could not be, as the bank had already lent it many times, making it impossible to reimburse all they owed. Indeed, if the government had not pledged to underwrite all deposits, then there would be a very good chance that the whole system would have collapsed.

If we accept that the Emperor is naked then the path to solving all our current financial problems becomes clearer.

Consider this following programme of reform:

Print cash and replace all the demand-deposits/IOUs that exist in the system with that cash. This means the government printing approx £850 billion in cash and injecting it directly into the vaults of the banks and into the accounts of individuals. Thus, if you deposited £100 once thinking it was “yours,” it now really exists in cash, with the bank acting as custodian of your money.

Mandate all banks to hold your cash (100% reserved) on demand at all times.

Wipe from the bank ledgers all the demand-deposits/IOUs as banks would not owe you money anymore. This means the “thin air” money disappears, to be replaced exactly with cash money. Note: this is not inflationary, as the cash replaces the demand-deposit which acted as money. As we have established, it is only thin-air that the banking system has created to facilitate the multiplicity of lending of the same bit of money, so its total replacement with cash would mean the money supply stays exactly the same.

Require all banks to lend real savings that people knowingly place with banks to lend to businesses to get a return of interest and capital back when the business repays that loan. This is nice, simple and safe utility banking. This is what Mervyn King advocates.

As you are not a creditor of the bank anymore, the banking system will only have its assets and its capital, i.e. no liabilities. This means that there never again could be a bank run.

As for the banks, not having you the depositor as a liability anymore, they will suddenly be £850 billion better off, with no current liabilities and only assets (loans to business etc), post reform. The government can now put those assets into Mutuals, which would then immediately pay off the national debt, and leave the banks in exactly the same position net worth wise as they were prior to the reform, owned by their existing shareholders. As the national debt is still just under the £850 billion, which would be available as surplus assets of the banks, this could still be achieved.

The boy in the story stood on his father’s shoulders. I stand on the shoulders of great men who have advocated part of this reform: Irving Fisher, the greatest American economist, the Nobel Prize winners Soddy, Hayek, Buchanan, Tobin, and Allais. Recently, Kotlikoff of Boston University has published an excellent book, “Jimmy Stewart is Dead” advocating a similar reform. It is endorsed by more Nobel Winners: Akerlof, Lucas, Fogel, Prescott, and Phelps. I count 36 endorsements from the great and the good for the book. All endorse Kotlikoff’s move to what he calls Limited Purpose Banking which is another way to get 100% reserved (i.e. secure) deposits backed by cash rather than thin-air.

The Economist Huerta De Soto, in “Money, Bank Credit & Economic Cycles,” has seen the opportunity that presents itself to reform for 100% money while also paying off the National Debt. Following on from this, I suggest a substantial wealth-creating tax cut for the people. Just like the boy in the story, I do hope that people start to realise that the emperor really has no clothes, and that an enlightened approach can address this.

A number of schemes are available, but I am provisionally a supporter of Jesus Huerta de Soto’s plan as described in “Money, Bank Credit and Economic Cycles”. Toby is explaining the first step of that plan.

I am not your constituency but I have a real disagreement with the plan Toby and you present here.

Why do you have to do all the shenanigans in between when all your plan is doing is this:
“… the government printing approx £850 billion in cash…
…which would then immediately pay off the national debt…”

Why all these change of hands, smoke and mirrors?

Let’s say John in your constituency owes the government taxes (£1000). Let’s say you print £1000 and ship them to John’s safe from where they will go directly to Her Majesty’s Revenue and Customs.

Then you wipe off John’s tax liability and now John is suddenly £1000 better off. So the Gov can take £1000 from John and invest it in mutuals and pay off the debt.

Why? The government can just print £1000 and plug whatever hole they have around with them.

Why bother John? Why all this paperwork, shipping and handling.

In your bio you say “I value achievement over process and humanity over bureaucracy.”

However your plan, described here by Toby is just a bureaucratic waste of time in attempt to make monetizing the debt look better than just running the presses.

I understand why you make that criticism, but it is misplaced. The money supply, as properly understood[1] is not changed by this reform which merely swaps credit money for paper money, creating no change to the money supply.

The national debt is paid off using the existing assets of banks. Those bank assets were created through credit expansion and it is therefore reasonable to require the banks to exchange them for cash, wiping out the credit money they created and stabilising the money supply.

I am not going to contribute further on this thread. After all that has been written here in explanation, the next course of action is for interested readers to see Jesus Huerta de Soto’s “Money, Bank Credit and Economic Cycles” which is available here:

If I got it right, the intention of printing (or simply expanding the central bank’s monetary base by) L850b has the beneficiary effect of stopping money inflation and deflation at the amount of fake and real money that already exists. Money supply = monetary base = something fix or fully predictable. Also, if you are introducing a 100% reserve requirement you have to “print” such amount of real money. Otherwise, enforcing a 100% reserve requirement only with the current monetary base would provoke such a big economic mess due to the huge amount of fake bank money that those thoughts would be better fit in a science fiction blog.

I know that the idea of issuing legal Bank of England money to cover fake bankers’ money is disgusting. “Let’s put all counterfeiters behind bars!” would be a natural reaction. But think that they have acted according to positive banking laws, so their counterfeiting is fully legal (until the restoration of the 100% reserve requirement). Think, for example, of the Argentina’s “Ley de Punto Final” after the end of the military dictatorship. It was disgusting but needed to move to democracy (or whatever the Kirchner’s regime is) It dictated the end of investigation and prosecution against people accused of political violence during the dictatorship because they acted according to the law and superiors’ orders (except for cases of murdering, forced disappearance of minors, and so on. In our case we can think of CDO issuance, junk bonds graded AAA, Maddoff’s-like finance, and so on)

About whether banks will be better off, yes, they will. Their solvency improve dramatically, since the cash custodian and payment system business is 100% backed with real money, no liquidity or solvency problems, and their separate credit intermediation businesses are insulated in separate mutual funds (as a simplification of the investment forms this separate activities may take) Butmore importantly, the economy is also better off

And about robbing the Brits, I am afraid we are late on this. The silent but effective inflationary robbery, perpetrated either by the Bank of England or by the commercial banks has already taken place. The idea is to stop it, and unless you are a banker or a senior government official, I suggest you to support.

Dear Antonio, let me start with a quote from Jesus Huerta de Soto:
“The fall of socialism in the countries of Eastern Europe was a historic event of the first magnitude, and there is no doubt that it caught most economics experts off guard. The issue is not only that economic science failed to rise to the occasion in the face of momentous historical circumstances which economists were unable to predict, but also, and this is even more serious, that it failed to provide mankind with the analytical tools necessary to prevent the grave errors committed.

In fact, economists have often done quite the opposite: they have used their scientific aura and prestige to justify and promote economic policies and social systems which have been patently unsuccessful and involved a disproportionate cost in human suffering.”

As a person who grew up in Eastern Europe and lived through 2 hyperinflations and sent money to friends in Argentina when their currency board collapsed – forgive my cynicism when economist’s aura is discussed.

I say: if you simply cover the banker’s money the bank will be in the same condition when the printed cash gets in the bank. In Toby’s plan banks are better off with the amount of the printed cash.

It is not a rocket science – he added money to the bank. But says he didn’t just print the money and he didn’t steal them from the people. Then where did the L850b came from? Did the money have babies? Did the demand deposit money cloned itself?

If Toby honestly say: we want to print L850b in new money – just this last time and never again – this would be honest.
Instead he says: “Thus, if you deposited £100 once thinking it was “yours,” it now really exists in cash, with the bank acting as custodian of your money.”

If I deposited £100 it is either in the bank or it is not in the bank. If it is not in the bank and you give £100 to the bank to represent what is not in the bank – means you give new money to the bank and the bank is better off.

Let me quote De Soto again:

“… we have taken special care to resist the erroneous view that economic phenomena have a factual, “objective” existence outside of the subjective interpretation and knowledge of them which humans generate when they act…”

I am human, I have a checking account, I act therefore my subjective interpretation about demand deposit banking is as valid as any “objective” one.

I am sorry the UK ran out of other people’s money, so is the USA unfortunately. Have emergency supply for 3-4 months (so you don’t get into situation where your monthly salary is not enough to buy you loaf of bread) and buy things with your cash.

However Toby was not honest with the public – insisting that when printing L850b he did not in fact print new money.
Liar, liar, pant on fire.

I agree with de Soto, mrg, he is brilliant, thank you for recommending his books.

However I am not able to find where de Soto is recommending printing new money to repay the sovereign debt. Yet. I keep reading in hope to find that, but if you can point me to the quote, I’ll be grateful.

If you have no intention to give away the L1000 you shouldn’t be announcing it.

Calling me stupid and infantile does not make printing L850b to make the banks L850b better – for the gov to confiscate – to repay the debt – look any better. It is no different than monetizing the debt.

If socialism has often been defended in scientific, political, and philosophical circles, it is because it was thought that the systematic use of coercion could make the process of social coordination much more effective.”

I am afraid Toby’s plan is exactly this – socialism. His idea is that the government can go through a dishonest way to achieve a state of honest money.

It is always the distant goal of bright, fair future for the socialists.

In Toby’s case it is the future of the 100% reserve and honest money.

It is always for the common good of a lot of people for the socialists. Even for the right-wing socialists.

If you can’t find an honest way to get to honest money – you are nothing but socialists who pick winners and losers because you believe in some utopia.

And I will tell you why your plan will not work. To quote de Soto:

“entrepreneurship consists of the typically human capacity to recognize the opportunities for profit which exist in one’s environment”

People will find a way to crack your little system to make money out of it. There is no press that fast and no law-maker that fast that can stop the entrepreneurs from making money out of any system.

You were supposed to be different. Is this what you came up with – neo-socialism.

Print some money – roll them from cup to cup so the viewers can lose the track – put them in your sleeve – pay the debt.

If this helps, I think Prof Huerta de Soto is clear about the printing new money to repay the sovereign debt,etc. Actually Toby’s plan I think follow’s Huerta de Soto’s 3rd Stage of his STAGES IN THE REFORM OF THE FINANCIAL AND BANKING SYSTEM, that you can find in HdeS’s book from page 789 ff.

This e-mail is intended solely for its recipients and should be considered confidential by all other parties. If you received this e-mail by mistake, we apologise and would be grateful if you would notify us immediately and then delete it from your system without sending it on to anyone else.
————-

When you say that Toby’s plan can be reduced to: “(i)… the government printing approx £850 billion in cash…, (ii)…which would then immediately pay off the national debt…” I am afraid that you have oversimplified the whole plan up to the point to make of it something totally despicable. If Toby’s plan stopped in the two steps you mention, then his plan would be of the kind that Mugabe implemented in Zimbabwe, which brought hyperinflation and ruined one of the most prosperous countries in Africa.

I think that his plan also includes (not as an option, but as essential parts of it): (iii) restore the 100% reserve requirement (banking supervisors are expected to enforce this rule), (iv) start removing all sort of State interventions in the banking system (namely: lender of last resort, government guarantees to retail deposits, and also to wholesale deposits today!!, and outrageous doctrines such as the one that argues that some banks are too big to fail.), and (v) split the banking sector into two kind of institutions, where contagion between the two would not be possible: cash custody and payment services (100% backed by cash), and credit risk intermediation with real savings.

I have no problem with restore the 100% reserve requirement (banking supervisors are expected to enforce this rule), (iv) start removing all sort of State interventions in the banking system (namely: lender of last resort, government guarantees to retail deposits, and also to wholesale deposits today!!, and outrageous doctrines such as the one that argues that some banks are too big to fail.), and (v) split the banking sector into two kind of institutions, where contagion between the two would not be possible: cash custody and payment services (100% backed by cash), and credit risk intermediation with real savings.

It is all good.

But why print L850b? If these bank notes are merely representing the money that already exist in the bank, then the bank will not be L850b better off when they arrive in the bank’s vault – the bank will be in the same condition.

In Toby’s plan the bank is L850b better off when the cash arrives – that means the L850b were added, not swapped.

And I feel strongly that I logically proved the L850b printed are new money and I want my L1000 reward.

Because after the UK starts printing L850b to ship to the banks to inject them into the accounts and wipe the demand deposits from bank’s books so the bank will be L850b better off – the only giant on whose shoulders Toby will be standing is Zimbabwe’s Mugabe.

well, Mencius Moldbug wants to rule out all maturity mismatching. He is against all borrowing short and lending long, i.e. not only lending out demand deposits but also against lending out time deposits for a longer term. He goes a step farther than Toby´s proposal which is reasonable when combined with swith to a gold standard. In fact, Toby´s proposal is far from being radical, but moderate. For a more radical proposal see: http://pcpe.libinst.cz/nppe/5_2/nppe5_2_2.pdf

Regarding your £1,000 reward, I wonder if you might clarify what you mean by “logically won’t work”. If you mean that someone must show that your plan is literally unimplementable at any cost, then of course your £1,000 is safe. If you require them to show that your proposal would not allow the national debt to be paid off, then your money is also safe (with the caveat that confiscating assets with a notional value of £850 billion may not raise £850 billion in revenue if you sell them all off at once).

I do not doubt that your proposal could be implemented, and that it might well allow the national debt to be paid off. However, I believe it has costs which you do not acknowledge in your blog post, and that these are sufficiently large to make it an undesirable reform.

It is unclear from your post whether you propose to outlaw all fractional-reserve accounts where people may withdraw their funds at any time, including instant access savings accounts, or whether your proposal applies only to current accounts.

If it is the latter, then your proposed reform would present people with the following choice: Pay warehousing fees on a 100%-reserve current account, or suffer the inconvenience of making frequent withdrawals from an instant access savings account. Given the high fixed costs and low variable costs of warehousing, I imagine the fees on 100%-reserve current accounts would be very similar regardless of how much money you had in them. Unless they were prepared to pay for everything in cash, people would need to have a current account. As such, I would expect people to keep almost as much money in current accounts as they do presently, and to suffer the warehousing fees.

(Note also that it would be more efficient to have the government
offer to print cash for any existing demand deposits, and forbid the
creation of any new ones, rather than printing it all up front.
Promises to print are cheaper to store than pieces of paper!)

You may well believe that the elimination of depositor runs on banks is worth these costs, but I think you should acknowledge in your proposal that these costs exist.

If your proposal is in fact to require 100% reserves for all instant access accounts, then your proposal would effectively prevent the banking system from performing its maturity transformation role. In order to earn a positive return on their money, savers (whether individual or institutional) would have to lend for fixed periods of time. A question of implementation now arises: What is the difference between a demand deposit on the one hand, and an overnight loan that renews automatically unless the lender explicitly cancels it? It seems that something very close to fractional-reserve banking as currently practiced could be achieved by having loans of the shortest legal or practical maturity that renewed automatically. Therefore, if you wish to prevent all fractional-reserve-type accounts, then you may need to impose further regulations on the kind of loan contracts people can enter into.

Unless you forbid any maturity mismatch whatsoever, that is, make it completely illegal to borrow short and lend long, then there will always be a risk of runs on financial institutions. Runs by depositors are only part of the problem; institutions can also fail due to “runs” by creditors who refuse to roll over their loans.

One thing banks do is to intermediate between savers and borrowers – to specialise in checking borrowers’ creditworthiness and thereby sparing savers from having to do this themselves. Banks could continue to play this role under your proposal. However, they currently also provide depositors with liquidity insurance by undertaking maturity transformation. That is, by pooling the deposits of millions of people, banks can offer them instant access while at the same time offering a higher rate of interest than they could if they were required to hold 100% reserves. People don’t generally know when they will need access to liquidity, but on average only a certain proportion of people will need it at any given time. The classic account of this maturity transformation role of banks, and the risk of runs that it creates, is the paper by Diamond and Dybvig (http://minneapolisfed.org/research/QR/QR2412.pdf). If you are not already familiar with this paper, I would strongly recommend it to you.

There are both private and state methods of dealing with bank runs. As I’m sure you know, Selgin and White believe that option clauses and other contractual solutions would effectively eliminate runs on banks. A 100% government guarantee of all deposits would have the same effect, but then of course there are enormous moral hazard problems.

So if you are not persuaded by Selgin and White’s arguments, and you do not want the government guaranteeing deposits, then abolishing fractional-reserve banking would seem to be the only remaining method of eliminating the possibility of bank runs. As I understand it, you also believe that fractional-reserve banking plays a crucial role in the business cycle (an issue on which I have not yet formed a considered judgement). If you believe that these costs are so high as to outweigh the benefits of maturity transformation, then I believe you are justified in advocating the abolition of fractional-reserve banking.

For my part, I believe that the benefits of maturity transformation are very substantial indeed; that contractual solutions of the kind Selgin and White suggest would probably go a long way towards eliminating bank runs; and that the business cycle probably has little if anything to do with fractional-reserve banking per se (although this is something I hope to give a lot more thought). As such, I respectfully disagree with your proposal.

The aim of this article was in 1,200 words (the top end of the attention span of the intelligent layman so I am told), in layman language to get the idea out to the layman public to get some criticism. I have had some academic feedback as well which I have found useful.

Is this internally consistent? Not is this practical? That is another matter. If internally consistent, it is then worth trying to find out a practical “devil in the detail” way of making it happen.

Your contention, yes it can work, no it will be not worth the cost.

Confirmation: outlaw fractional reserve funds.

Custodian fees are very cheap. I use these at Kass Bank [ed: Kas Bank], I suggest you look up, this is a custodian bank only. Not as expensive as you would think.

However, in a brave new world of fixed money supply, think of the following that I wrote to another, forgive me for recycling – In summary, the contention is that all money in demand deposits that is called by the banks misleadingly “instant access savings” post reform would move to timed deposits / bonds and bid up prices etc. His contention was in the USA only 14% are demand deposits in the pure form and 86% are what the banks called instant access, but are timed deposits.

Interest Rate Fixation on Instant Access Savings

With a fixed money supply, the on going productivity gains by the entrepreneurs means that more goods will be offered for sale at better prices, this means purchasing power of money has gone up. As this is the only way that we have economic progress with a fixed money supply, people will be more fixated on what their money buys rather than what the numerical value is supposedly going up by.

Are 14% or 86% of Demand Deposits Available to Pay off the Debt?

At the point of reform £850 bn are, so the reform does pay off the debt.

If people move cash there after to buy short term savings to pay interest, this makes no difference to the debt repayment as it is done.

Price Disruptions

I concur with you that price realignments will take place as people adjust to the brave new world. This is wholly right and good as what consumers want will be more aligned with what producers produce. What producers produce will correspond more closely with what savers want to buy when they spend their money. Only bubble based activity will be deprived of credit.

N.B. I like your “promise to print suggestion”

Maturity mismatching is a problem. In the current arrangements, we have the Leviathan State sucking the life out of private savings when pension funds (investing long) and life companies (investing for life) plough money into so called “risk free” government sovereign debt. If the state has no desire for money and its debt is paid off and we have constitutional measure to prevent debt issuance, then once again , those great institutions , along with the mutuals will play their role with maturity matching on the long side. The short side no one seems to have much of an issue with.

“What is the difference between a demand deposit on the one hand, and an overnight loan that renews automatically unless the lender explicitly cancels it?”

In a post reform world, a physical unit needs to pass each night to comply with the understanding of what a saving is: a surrender of the purchasing power of £X and lending it to someone else to use and exchange for getting £x = £y in interest back at some point in time. Note this would be expensive and can not function as a fractional reserve account and would insure bankers behaved and got involved with sensible transactions like we all have to do in business.

I think you’re in danger of taking yourself down a blind alley with regards to maturity matching – see above point.

I believe I have read the Diamond and Dybvig paper – however I will re read. I have vague memories of binning it as it suggested that to keep the math elegant, absent bankruptcy costs and we can show that any level of leverage is OK (in fact – the more the better) as one persons leverage is another persons savings and so on and so forth. I may be thinking of another paper, but I binned it due to is fantastical assumptions. I am also aware that to the mainstream economists, this is a fine thing to assume, hence I am not a mainstream economist.

Selgin and White’s proposals I would gladly accept tomorrow if offered a binary choice of what we have now and what we would have under their system. I would rather my method now to deal with the debt, then look to develop out further free market reforms; abolish legal tender, route money in commodities chosen by the free interplay of market forces etc, abolish the central bank and so on and so forth. Can’t say all that in 1,200 words!

I am impressed that your money (or at least some of your assets) are
where your proverbial mouth is, that is, in a custodian account. I
understand that this is an intrusive personal question, but if you do
not mind answering it then I would be very interested to know whether
you keep any cash in your custodian account. (A Google search for Kass
Bank turned up no plausible results – could you link me to it?) [ed: that was a typo; Toby meant Kas Bank]

I do not have a strongly-held position on what proportion of their funds people would choose to keep in custodian-type accounts versus time deposits under your proposal. In my discussion of this issue in my original email, I merely wished to point out that the payment of custodian fees and/or the inconvenience of arranging one’s time deposits so as to have sufficient access to liquidity are costs associated with your proposal. The magnitude of these costs is ultimately an empirical matter, and I must defer to your greater familiarity with these matters.

I’m afraid I haven’t understood your paragraph on maturity mismatching. Is it your desire to prevent all institutions from having mismatched liabilities, or simply to prohibit maturity mismatching in the case of people’s bank accounts? In other words, would you allow a bank issuing a 20-year mortgage to fund it via a series of 1-year bonds, or would you require that it acquire liabilities of exactly the same maturity as its assets?

I stand by my contention that something akin to fractional-reserve could be synthesised with continuously-renewed overnight loans. In fact, I think it may be a matter of mere semantics whether we in fact have such a system today. Suppose I have a current account with a bank, in which I have deposited £100 in cash. You state (http://www.cobdencentre.org/tag/carr-v-carr-1811/) that since Carr v Carr in 1811, this has been legally interpreted as a loan by me of £100 to the bank. Suppose that I decide one day to purchase a book costing £10, and to do so using a debit card linked to my bank account. My understanding is that it is not until the night of the transaction that the £10 is transferred from my account to that of the bookshop. Can we not interpret this transaction as me saying to my bank, “I do not wish to roll over £10 worth of my £100 loan tomorrow – please deposit the repaid funds into the account of bookshop X”, and the bookshop simultaneously agreeing to loan its bank an extra £10?

My overarching point is that engaging in maturity transformation/mismatching is exactly equivalent to holding fractional reserves. Depositors benefit from banks engaging in maturity mismatching because it means they can get some of the benefits of long-term investments while retaining the right to withdraw their funds at any time. This benefit is only available if the bank is permitted to hold fractional reserves; otherwise, the bank cannot invest any of its customers’ demand deposits in long-term projects.

So if you wish to outlaw all maturity mismatching, I humbly submit that you should acknowledge this explicitly in your proposal. A quick Googling reveals some support for this idea (see, for example, http://winterspeak.blogspot.com/2008/06/financial-regulation.html), and no doubt some of your 36 may have advocated it at some point.

If, on the other hand, your intention is to forbid maturity mismatch in the case of bank accounts but not in other cases, then I would be genuinely very interested to hear your thoughts on why allowing maturity transformation is desirable in these other cases but not in retail banking.

Incidentally I do not believe it is necessary, even under a system of 100% reserves, for physical units of money to pass between banks. I forgo £10 worth of purchasing power if £10 is docked electronically from my current account just as surely as if I hand over a £10 note, no? Just as I think the government could print cash to cover bank deposits on demand under your proposal, I also think that banks could transfer cash to one another to cover requests for redemption on demand.

After the reforms I could launch “Current’s 2-day” bond. It roles over every 2-days into another 2-day bond. Since it’s a two day bond it’s not a current liability, and doesn’t have to be 100% reserved.

I think that if I owned a large bank then people would use my 2-bond, in paper and electronic forms, as the medium-of-exchange rather than 100% reserved money. Most traders wouldn’t worry too much about not having access to the money for 2-days. I could pay before the 2-days as a goodwill gesture in any case.

Scottish banknotes with option-clauses were somewhat similar, since the bank could always take the option of paying a few weeks later rather than redeeming.

Obviously any practical version of Toby’s proposal would have to contain a specific time period. Within that time period any debt-contract must be 100% reserved. There must be a law against making good debt-contracts before the contracted time.

Incidentally, in your post before this one I think you take maturity mismatching too seriously. Even if a bank doesn’t perform maturity mismatching then there may be runs. Let’s suppose the savings-and-loans business goes wrong because of bad debts. Who then will believe that the bank won’t resort to maturity mismatching from it’s existing good debts?

Anon1,
you say:Incidentally I do not believe it is necessary, even under a system of 100% reserves, for physical units of money to pass between banks. I forgo £10 worth of purchasing power if £10 is docked electronically from my current account just as surely as if I hand over a £10 note, no?

I say: They have to print the money in Toby’s plan, because if they don’t print it they have to lock bank’s assets corresponding to the demand deposits in the bank to have 100% reserve.

Then the bank will be L850b worst off and there will be nothing for the gov to confiscate and put into mutuals.

So they print it and lock the gov cash in vaults – the bank is better off – the gov confiscates the money – puts them in mutuals.

I agree with your overarching point: banks “engaging in maturity transformation/mismatching is exactly equivalent to holding fractional reserves”. And I strongly endorse your suggestion to Toby that “if you wish to outlaw all maturity mismatching… you should acknowledge this explicitly in your proposal.” Banks key role, along with cash custody and services, is credit intermediation between savers and borrowers – “as firms specialised in assessing borrowers’ creditworthiness and thereby sparing savers from having to do this themselves”. This is what banks do! Maturity transformation is something for savers, consumers, investors and entrepreneurs to decide, according to their time preferences and capital calculations. Banks simply reflect this preference in their financial structure and financial products issuance. Also, with the 100% reserve requirement, you do not need “to outlaw all maturity mismatching”. They would naturally disappear, at least in the shortest terms, forced by the need to comply with the 100% reserve requirement.

Actually, the whole idea of maturity matching in banks balance sheets is, in my opinion THE KEY TENET of financial stability. If it fails, financial stability is just a utopian thought that can only be possible with massive State intervention (and all people’s fingers crossed).

You also say that: “Depositors benefit from banks engaging in maturity mismatching because it means they can get some of the benefits of long-term investments while retaining the right to withdraw their funds at any time.” Yes, depositors get some benefits with this fraudulent money…, at the cost of economically devastating financial crisis, which in the end they will have to pay through present and future taxes. But the ones who really benefit from the fractional reserve banking are the bankers themselves. They can expand the monetary supply at will, with no other limitations than banks capital requirements and the cost of financing, and engage in extremely profitable carry-trade business of borrowing short term, to invest long-term. No legal or illegal industry today is as profitable as fractional reserve banking. And this is only possible thanks to the State’s support to the fractional reserve system. As we said before, remove lender of last resort, State guarantees on bank deposits, doctrines that do not allow banks too big to fail, and the whole fractional reserve system would collapse. Without State intervention, the economy would move naturally to a 100% reserve requirement, although without some State rules guiding this transition today, the movement could be too painful.

I also agree with you that “something akin to fractional-reserve could be synthesised with continuously-renewed overnight loans,” or, I would say, synthesised with whatever financial engineering can create to circumvent the 100% reserve requirement (now technologies allow for financial wonders, as the current crisis has taught us). Actually, this is what bankers and governments have been trying since the beginning of banking. But they have not been so successful until today with the arrival of central banks creating fiat money. So no doubt that bankers and governments will continue to circumvent the 100% reserve requirement. That is why we need a well-trained, smart and reputable banking supervisors (better: inspectors) that make sure that the 100% reserve requirement in kept in substance not merely “as a matter of mere semantics.”

Finally, you say you “do not have a strongly-held position on what proportion of their funds people would choose to keep in custodian-type accounts versus time deposits under your proposal.” Actually, nobody knows. Not even the most brilliant and wisest of the central-planning bureaucrats. So we should not worry about this. We should worry about setting out fair rules that allow people work for their own benefit and the common good, without distorting State intervention.

I’m going right to the point of our disagreement. See comments between the dashed lines. (I extend apologies to Ellie for any offensive elitism.)

6. You have demonstrated that I have not made this reform proposal clear enough to you.
I copy and paste an answer I gave the commentator PeterMartin earlier
Peter asks.

â€œConsider this scenario. Maybe an illustration, or an example, will help everyone understand a little easier.
A bank currently has approximately Â£100 million in deposits and Â£100 million in loans. The stock market vaulation of the bank, through its assets, its business value, and own internal capital etc, is $10 million
The taxpayer makes a gift of Â£100 million so now the bank is worth Â£110 million and each account holder has real money in their account.

————————————————————-

[The taxpayer makes a gift — this is the difficulty. (I think this was missing in your initial 7 points, Ellie caught this, I missed it) The British Treasury created L100 million in cash for your demand depositors, now you have been relieved of your responsibility to the demand depositors but now have the same responsibility to the British Treasury. As the L100 million in loans which the Bank of Toby lent from the Demand Deposits must now be paid back to the British Treasury as the principal amounts are paid-off. This way the inflationary effects will be eliminated. There will be a time, at the begining of the process, where all the L100 million cash demand deposits and the L100 million loans from those deposits will be in the hands of the economy at the same time.]

[If you choose to characterize this as a gift then the L100 million in loans, AND the L100 million in cash demand deposits, will remain in the economy and the funds be lent again rather than being liquidated by return to the British Treasury. This is the inflationary doubling effect. ]

[When your new system is initialized the effects of the fractional reserve loans will still be manifest. but only about 2.5% of the L100 million will be in the bank, the remainder in the economy as loans (for simplicity just assume L100 million). Once the British Treasury provides cash to all your demand depositors we now have 100% of the L100 million in demand deposits in the economy too! So at the outset the currency available to the economy has doubled. Now will the demand deposits immediately be spent just because they have become fully cash based — probably not — but some figure in between 0 and L100 million will be. ]

[If the L100 million in loans based on the old system demand deposits are allowed to self-liquidate by returning the principal amounts, as the borrowers extinguish their obligations, to the British Treasury (which issued the L100 million in demand deposits) then the inflationary effect will slowly be reduced to zero.]

[if the taxpayer is going to make a gift to the banking system — then just do it directly, as was done with TARP in the US, (I don’t advocate this solution, I think it is similar to the greatest theft in American history, TARP, bankruptcy would have been preferable) all of these intermediate steps just add suspicion in the minds of the voters and taxpayers. In addition you could amend the banking laws to prevent fractional reserve lending. (I don’t recommend this, it will cause a severe credit crunch and deflation when Britain least needs it). I believe you mentioned that Demand Deposits are already assured by the British Treasury/Government so anytime the Demand Deposits are pressed for cash it will be there anyway. In effect this would relieve any bank run but still leave the bank obligated to the Demand Depositors]

[This is the crux of our disagreement, there is a much simpler and direct way to accomplish your goals. I hate to see England fall into the same mess we now have in the US]

[In the US the banking crisis was centered on the Investment Banks, such as Lehman, Bear-Stearns, Goldman-Sachs, JP Morgan, Morgan-Stanley, Merrill Lynch — and some formerly Commercial Banks which had developed Investment Banking divisions with the demise of the Glass-Steagall act in 1999, such as Wells-Fargo and Bank of America.]

[Glass-Steagall permitted Commercial Banks the protection of the Federal Government (US Taxpayer), but denied this protection to Investment Banks. In late 2008 Goldman-Sachs became an Commercial bank in 24 hours, a process that usually takes 6 months. GS did this for one reason — it needed TARP funds to avoid bankruptcy. Then Treasury Secretary Hank Paulson, architect of TARP, had just left the CEO chair at Goldman-Sachs in 2006 to head the US Treasury.]

[Commercial Banks are those with retail street offices which grant consumer and business loans. Investment Banks underwrite stock and bond offerings (including the securitization and re-sale of mortgage based and asset based instruments), perform mergers and acquisitions, trade currencies, and trade and create derivatives with leverages as high as 35 to 1.]

[The massive over-leveraging of these institutions almost guaranteed that there would be a near future investment gone bad that would bankrupt the firm. [It’s like riding a motorcycle at 100 miles/hr everyday no matter what the conditions of the road] Now the US Taxpayer and Commercial Banks must pay the costs for this foolish high stakes gambling called Investment Banking. Had Glass-Steagall (only 51 pages in length) been in force the Investment Banks could have gambled as much as they liked but the losses would have been limited to the owners and investors in the particular firms, which is as it should be. Now Congress is ignoring 100 years of sound Bankruptcy law and creating volumes of new law (1,400 pages and growing)to determine when the “systemic risk” posed by an Investment Bank should lead to its’ dismantling.]

————————————————————-

Again, thanks for your attention to the details of my and others’ comments.

TARP was announced as a loan to the banks. I understand they are finding creative ways to steal the money, but the TARP was announced as a loan to us laymans. We deserve at least that – for the politicians to at least pretend they are doing a sane thing.

I have no problem if in Toby’s plan the Treasury gives a loan to the banks while they are transitioning to 100% reserve.

I have no problem if in Toby’s plan the Treasury gives a gift to the banks (it is a problem to the British tax-payers) while they are transitioning to 100% reserve.

I have no problem with printing money and giving them to the banks (or to the depositors – either way) while transitioning to 100% (The only British currency I own is a 2 ponds coin with ‘Standing on the shoulders of giants’ inscription)

I have problem with printing money and pretending you didn’t.
To BS a BSer they have to come up with something better than: “we didn’t print new L850b – the banks are just magically L850b better off now that we did print L850b”

I do not know how to make you undertstand this, you say “The British Treasury created L100 million in cash for your demand depositors, now you have been relieved of your responsibility to the demand depositors but now have the same responsibility to the British Treasury. ” I say, fact, the British Treasury can print its paper and give it to whom it wants and whosoever has been given it can have no liability to the British Treasury. It can print this paper money and replace the existing money / demand deposits with no change in the money supply and no new liability created.

“In the banking industry, reform would revolve around the
concept of converting today’s private bankers into mere managersof mutual funds. Specifically, once authorities have
announced and explained the reform to citizens, they should
give the holders of current demand deposits (or their equivalent)the opportunity to manifest their desire, within a prudent time period, to replace these deposits with mutual-fund shares….

the central bank, as Frank H. Knight recommends, should print legal bills for an overall amount equal to the aggregate of all demand deposits and equivalents recorded on the balance sheets of all the banks under its control (excluding the sum represented by the above exchange option)…

We must point out that Hart suggests the new paper
money the central bank prints to back deposits be handed over
to banks as a gift. If this occurs, it is obvious that banks’ balancesheets will reflect an enormous surplus, one precisely equal to the sum of demand deposits backed 100 percent by a reserve…

Hart’s proposal that the basis of the reform consist of simply giving banks the sum of the bills they need to reach a 100-percent reserve ratio is a bitter pill to swallow…”

No kidding!

You people are crazy and if you are the people who rule the world – it is a very sad day for the world.

I will not bother you any longer.

Realizing you really mean this creepy ideas is disturbing.

You are no conservatives.

You are socialists who cannot live with the idea that the banks created wealth that is not shared by the government.

Hi Steven, what you say is very sensible. However, it is not close to what was said in the blog post. Note the opening premise of the post “I offer a £1,000 reward for anyone who can tell me why this logically won’t work” where I note the word “this” not the words “some improvement of this”.

Thank you for your comments and Steve for jumping in during my absence.

Demand deposits are 100% reserved and timed deposits are lent. If you place your money in a safe deposit it is 100% reserved to your demand. If you choose to lend it out and relinquish ownership of it to the borrower for the duration of the loan, in return for the capital back and interest etc, you need no reserve as you have lent it. It is impossible to reserve something with you no longer own.

So 2 and 4 can and do happen at the same time with on demand money 100% reserved with no implications for lent money.

It turns out that your points 2 and 4 are actually proposing nothing:
Point (2): Banks already provide safety deposit boxes – so to mandate their provision (100% reserved accounts are basically stores of cash as notes and coins) is really no change.
Point (4): Banks already do this too.

What you are actually trying to mandate is this:
Banks are not allowed to lend out deposits at the BoE reserve requirements (which is what is currently mandated).
[note that if this isn’t what you are actually saying then you will have to keep repeating the process in your point (1) – hence my confidence that this is what you actually mean]

Currently the BoE money supply instruments (rooted in the BoE ‘Base Rate’) make use of banks’ ability to lend out money at the fixed BoE reserve requirement to control the money supply. If Banks are not allowed to lend out deposits at the BoE reserve requirement then the money supply, and thus price inflation, will be out of control.

If you take away the main instrument of money supply control from the BoE then we are left with the only other instrument of money supply control that falls under centralised governmental control: Government borrowing. In order to provide a sensible level of price inflation (let’s take the current 2% RPI target as that level) the Government would be forced to take on orders of magnitude higher levels of debt – which, let’s face it, would be inappropriate.

Whilst the initial printing of money is not inflationary, the outcome of your complete proposal is an out of control money supply (and thus out of control prices – inflation-deflation), which is why your proposal won’t work.

Mark, there is no reserve requirement at the Bank of England, I think you will find it was done away with during the ill thought out financial reforms of the Thatcher government. I say ill thought out as that is why they have largely lost their ability to control the money supply, something that you think my fixing of it will actually achieve. This is 100% the wrong way around.

Banks on lend deposits on average 33 times, aka creating credit out of thin air – grow the money supply. I seek to stop this and make them custodian of deposited money for those that want it and intermediaries between saver and lender as opposed to being an intermediary and multiple credit creator out of thin air money substitute provider.

If the money supply was fixed as I suggest, then it is impossible for the money supply to be out of control as it is now, it is static. At the moment is has declined (recession). As more borrowers pay off loans than take them out, the credit induced loan that was created out of thin air goes back to being thin air once it is paid, hence we have a money deflation at the moment (recession).

When you move to 100% reserves you cannot have a money deflation unless you physically destroy the money by burning it or doing something drastic like that. When a borrower pays back 100% reserved cash, then the lender gets the cash back i.e. no money deflation or money inflation.

I would urge you to read again as I do not think you have a sufficient grasp of what is being said (apologies for being publically direct) and you are inaccurate in the way you describe the reserve requirement and the why money is created and controlled.

If there is no reserve requirement then why are the banks required to hold reserves at the BoE?

Toby, your scheme does not fix the money supply as you are only suggesting 100% reserves for a tiny proportion of the £850 billion – after all why would people lock up their existing wealth rather than use it to help create more wealth. Allow me to illustrate:

If you are going to allow banks to lend timed deposits out to borrowers then how do you propose to control the money supply? After all, these loans can be re-deposited and then re-loaned a huge number of times (as there is no reserve requirement) leading to a massive increase in the money supply – e.g. Person A makes a timed deposit of £850 in cash to be lent out. It is lent out to Person B who spends it with Person C who makes a timed deposit which is then lent out to Person D who spends it with Person E who then makes a time deposit which is lent out to Person F who spends it with Person G… and so on. When would you like it to stop? When that £850 becomes a million pounds on time deposit? Let’s multiply this example by a billion so that we have your £850 billion starting amount, I guess that we could quickly multiply this up to £850 trillion. Wow, price inflation would be horrific!

Your plan falls down because you have no way to control the money supply, which will quickly spiral out of control. Currently money supply is being controlled to keep CPI within a narrow band. Of course there are many arguments that say targeting only CPI and not targeting asset prices was wrong, but controlling asset prices (by which they largely mean land – as more of everything else can be supplied to meet demand and keep prices in check) via money supply is, by some (including myself), thought to be the entirely wrong way of checking boom and bust.

I should note that your plan to have a static money supply is also fraught as it would (if it worked, which it won’t), assuming that we continue to see an increase in the amount of goods at market (as we have done throughout human history and pre-history), cause price deflation – where items get inexorably cheaper and cheaper, as measured by their price in a currency of rapidly increasing value (due to its limited supply). Money supply should at least match the supply of goods to market. In fact, to avoid hoarding of cash and lack of investment, our society deems it important to have slight price inflation – hence the 2% CPI target. Fortunately your scheme doesn’t result in a static money supply (as I have illustrated in this comment), rather it results in uncontrolled price inflation as the money supply spirals out of control!

I should point out that currently money supply is being controlled to keep CPI within a narrow band. This is not the same argument as saying that money supply itself is being kept in a tight band (it isn’t, it was spiralling up and now is running fairly level) – I’m just pointing out that the instruments of money supply control (the Base Rate and reserve requirements, etc.) are very effective (more effective than at any point in history previously) at controlling the money supply. Just because we both believe that asset prices shouldn’t have been allowed to inflate is beside the point (even though this is the ultimate problem). If we can control asset prices (and I suggest Land Value Tax – LVT) then the current instruments of money supply control will be ideal to provide us with a stable future, which your scheme cannot.

On another point:
Thank you for being direct. However, it is clear to me that you have fallen for the myths surrounding ‘creating money out of thin air’ – naturally all credit/debt based money (as opposed to asset money such as gold coins) is by definition, and necessarily, created out of thin air as it is simply a promise to pay (transfer assets of some kind) later (to compensate for the transfer of assets now). The fact is that virtually the whole world uses credit based money virtually all of the time. Indeed the (printed) cash that you are talking about is also credit based money (created by the BoE to buy gilts from the market) and is (was) necessarily created ‘out of thin air’.
If you seek to make the creation of money out of thin air then you will need to stop not only the banks, but also the BoE/Treasury, you will need to stop Joe Public from scribbling IOUs on pieces of paper – basically you will need to stop everyone from making any types of promises to repay full stop!

Toby, I should have included the word ‘velocity’ in my comment immediately above.
Money supply = quantity x velocity
naturally those £850 pound loans cannot be spent at the same time and thus velocity is an important factor. Velocity will change over the years as business process by the lending banks, spending borrowers and depositing sellers change. Hence the need for instruments to control money supply (and therefore price inflation).

For a proposed system to work logically, it is a logical requirement that it is logically consistent and logically coherent. In your proposal, interest earning assets are transfered and replaced with non interest earning assets. For your proposal to work it is a requirement that there is no compensation to the banks shareholders, employees and interest earning depositors. But that does not form part of the proposal, and thus your proposal is not logically coherent which therefore precludes it from working logically. Which satifies your requirement that it be shown that it logically won’t work.

Thank you for your comments. In a 1,200 word article you can not spell out every single circumstance etc. In the comments section the point you make is drawn out and answered.

£380 bn of demand deposits out of £850 bn are interest earning assets i.e. what the banks rather disingenuously called “instant access savings.” Due to the fact that they are instant access, I would expect a portion of these will want to remain cash backed for occasional uses or emergency use and the rest would move to timed deposits proper. To what extent this is, I do not know. Why this would not work as you suggest, I am miffed.

Bank shareholders need no compensation as they are left with a bank with the same net worth post reform as it was pre reform.

I do not understand your point re employees as these will still be there so what compensation do they need?

The non interest earning assets is the newly printed money. The interest earning assets is the banks loans to buisinesses etc.
The cash is placed with the banks. The Interest earning assets are transfered to the Mutuals.
The cash does not return the banks to the same net value as it does not replace the value of the banks interest earning assets. The cash does not have the same value to the banks as the interest earning assets, as it not creating a revenue of interest for the banks. That is the flaw in your proposal.

Cash is not an asset of the bank pre or post reform unless it is the shareholders funds or retained profits, otherwise it is a liability.

Post reform the banks lend out real cash and get a return on it. As they are not multiple on lending, they will get less of a cash return. They will have to adjust back their businesses accordingly to make themselves learner and meaner (less status flash offices, less big bonuses all subsidised by you and me) in a more honest world where they have to compete to earn money like the rest of us by selling goods and services without the need of a central bank to bail them out, deposit insurance, a grant of legal privilege to not pay creditors on demand etc. They will have to once again be good at maturity matching and will not have the privilege of using the taxpayer subsidised discount window at the BoE. Oh what a shame, they will have to operate within the commercial law like any other business!

This article and the links enclosed may be of interest to you should you have the time to look at it.

This is posted on behalf of Dr William Luther with his permission – it was sent to my private email and I reprint here. Toby Baxendale.

“Mr. Baxendale,

I believe your proposal has a theoretical error. I have tried to point it out in the attached PDF. I look forward to your reply.

Take care,

Will

Mr. Baxendale,

I am quite sympathetic to your concerns regarding sovereign debt, unsound money, and
oversized governments. As such, I am intrigued by your proposal, which aims to address
all three birds with one stone. Unfortunately, I believe your argument suffers from a
logical error: you implicitly create a large profit opportunity but expect entrepreneurs not
to exploit this opportunity. In the next few paragraphs, I will attempt to make my point
more clear.

For the most part, individuals willingly deposit their money in banks that hold fractional
reserves. Some Austrian economists have argued that fractional reserve banks (FRBs) are
fraudulent as individuals are not aware that their money is being loaned to others. While
there are no doubt some who unwittingly deposit their hard-earned cash in FRBs, most
understand they are trading cash for claims to cash.1 Why do they do this? The obvious
answer is that they are compensated for the additional risk. Bankers earn interest from
lending. They can share a portion of this interest with depositors—or at the very least,
reduce the warehouse fees below what would prevail in the absence of fractional reserve
banking. Hence, some individuals believe the cost associated with the risk of losing
deposits in a fractional reserve bank is compensated for by (1) security provided by
banks, (2) ease of payment made possible by check or debit card, (3) interest paid on
deposits, or (4) some combination of the three. I will henceforth refer to any remaining
mutual benefits of fractional reserve banking as a profit opportunity, since bankers and
depositors who spot the mutual gain and act accordingly will be rewarded.
So what happens if the government replaces demand deposits with cash and prevents
banks from holding fractional reserves? Assuming bankers and depositors attempt to
maximize their private profits:

1.
Banks will reduce their holdings of cash balances, charge a fee for holding
cash balances, and/or reduce the services provided for cash balances. While
banks will still earn interest on lending balances demarcated “real savings,” they
will no longer earn interest on cash balances held at the bank for security or ease
of transactions by check or debit cards. However, holding the cash in safe vaults
and providing transaction services comes at a cost. So banks will be able to
increase profits by either reducing the amount of cash balances held, charging a
fee greater than the cost of maintaining cash accounts, and/or reducing the
services provided for cash accounts. Mandating that banks hold 100% reserves for
cash accounts on demand at all times, as you propose, does not require that banks
__________________________________________________________________________________
1 If you find my assertion—that most
are aware of what fractional reserve banking entails
and deposit their cash nonetheless—problematic, I would be willing to adjust it so as to
make a much weaker claim: a few individuals knowingly deposit cash in FRBs. This
weaker assumption seems much harder to deny. Prominent free-bankers like Lawrence H.
White, George Selgin, and Steven Horwitz cannot be said to be ignorant of the
institutions and yet continue to make deposits. Substituting “a few” for “most” in my
claim does not affect the significance of the argument, but only the magnitude.
__________________________________________________________________________________

hold cash accounts. It merely stipulates that iif
they hold cash accounts they must
be backed by 100% reserves available on demand. Nor does the requirement
prevent banks from charging a fee or reducing the level of services they provide.
Therefore, the mandate you propose will result in depositors holding more cash
on hand (outside of the banking system) then they otherwise would. And those
who knowingly participated in the fractional reserve system before the mandate
was enacted would presumably like to continue to do so. They have more cash on
hand than they would like to hold and would be willing to reduce their holdings of
cash for some interest-bearing asset that is typically redeemable for cash on
demand but has a small chance of being irredeemable.

2.
Entrepreneurs will find a way to exploit this profit opportunity. Perhaps they
will merely break the law. Perhaps they will create an asset that complies with the
law as written but subverts the law as intended. Behavioral symmetry requires
that individuals who act purposefully to exploit profit opportunities in one context
do the same in other contexts, so long as the incentives structure remains the
same.
Hence, your policy proposal amounts to expanding the monetary base by up to £850
billion (depending on how successful entrepreneurs are).

One might argue that this is a mere practical problem and not a theoretical error. If only
one could design a law that includes all the possible workarounds and is perfectly
enforced, the problem I point out would disappear. But it is not a practical problem; it is a
matter of theoretical soundness. First, New Institutional Economics has taught us a lot
about the difficulty of writing perfect contracts. Therefore, the most appropriate
assumption to employ in a theory where contracts (in this case, the law) play a crucial
role is that individuals are incapable of drafting perfect contracts. Second, if contracts
cannot do the theoretical “work,” you must explain what actually does. Failing to detail a
mechanism is akin to assuming behavioral asymmetry. You are merely stating that
individuals behave one way when there isn’t a law and another when there is. I submit
that this is a theoretical error.

I look forward to your reply.

Take care,

William Luther”

My Response

“Your suggestion is that we create a law that says “you can not do this
> activity” and a number of people will try and do that same activity in
> another way. We have in this country income tax for higher rate payers
> at 50% and capital gains tax is 18% and what a surprise more and more
> people will try to shift income to capital gain. A whole new set of
> laws kick in that targets income shifting like this and at the margin,
> cat and mouse is played with the authorities on this matter between
> them and the evader. Note, I say at the margin as this is what it
> always is. Most people are law abiding. Make the risk very high for
> disobeying , as Sir Isaac Newton did as Master of the Mint and execute
> people who abused 100% reserves, and you get the law enforced in the
> overwhelming majority.
> I do not suggest death, but stiff jail sentences!
>
> People accept the current arrangements because there is a lender of
> last resort propping the system up. There is deposit insurance
> generously funded by the taxpayer to stop their RATIONAL fears of a
> bank run. Absent all of this and in a true free market, the banking
> system would soon only operate as I have described.
>
> Banks should charge for services rendered, why not? Maybe they will
> choose to subsidise the custodianship of cash storage. I sell fish for
> a living and to get hotels and restaurants to buy all of our fish
> species we sell, we have to discount the fastest moving lines, for
> example the salmon, and sell for virtually nothing. We are happy to do
> this as we work our margin in on the less important lines to our
> customers. Tesco sell cans of beans at £0.07p. This can not be even
> covering direct costs, but it gets people to walk into their store to
> buy other things that they make a full and sustainable margin on.
> Milton Friedman in a “Program for Monetary Stability”
> recommends a rule based 2% per year central bank introduction of money
> into the system so that banks can pay interest on deposits.
> This may well be another way of looking at things before people become
> accustomed to increasing purchasing power of money being the key
> indicator of prosperity as would be the case under a 100% reserved
> system.
>
> Your assertion that most people are aware they hold fractional
> reserves and all that that entails is desperately wrong. I
> commissioned a survey in 2009 of 2000 people asking them about their
> banking. We will publish in full on Cobden at some point in time in
> the future and I will alert you. At best I think we can conclude they
> are confused! I enclose the survey here… And a comment by the Prof
> who ran the project for us – they are his comments only.
>
> My take is the overwhelming majority think the money in the bank is
> theirs and they all want convenient access which implies it must be
> safe, which implies it must be there not lent, but in the majority
> they know it is lent = confusion.”

> People accept the current arrangements because there is a lender of
> last resort propping the system up. There is deposit insurance
> generously funded by the taxpayer to stop their RATIONAL fears of a
> bank run. Absent all of this and in a true free market, the banking
> system would soon only operate as I have described.

That’s very doubtful. In the period of Scottish free banking there was no deposit insurance, but people preferred to use FRB banks. Full reserve banking never arose. In fact, reserves dropped to tiny amounts.

The rational fear behind bank runs is that the bank is insolvent. That it’s assets are less than it’s liabilities. Using 100% reserve can’t prevent this problem. The liquidity risk – the risk that a large number of depositors just happen to want their money on the same day – is insignificant.

Tell that to Northern Rock creditors in July 2007. Tell that to all depositors, billions of people around the world today and see how they respond! I cannot believe you are even saying this in a serious fashion. You must be trying to wind me up.

Scotland is much loved as an example of fractional reserve free banking. The fact that tragic credit induced booms and bust happened in 1770,72,78,93,97, 1802-03, 1809-10, 1818-19, 1825-26, 1836-37, 1839, 47, is glossed over by supporters of Scottish fractional reserve free banking. Bail out then was not the done thing, straight forward bankruptcy and financial clearout was the MO at the time. Sidney Checkland , Scottish Banking: A History , 1695-1973 is good on this detail. The advent of the all providing big state and its willingness to socialise private losses is the prevalent method today. As we know it can be provided, we are right to rationally seek it. The two feed off each other.

> Tell that to Northern Rock creditors in July 2007. Tell that to
> all depositors, billions of people around the world today and
> see how they respond! I cannot believe you are even saying this
> in a serious fashion. You must be trying to wind me up.

I’m absolutely serious. Let’s suppose ten thousand account holders had converged on a different bank, not Northern Rock, but a solvent bank. What would have happened then?

Well, if the bank were solvent then it could borrow from other banks to fund the redemptions. Banks often do this, if one branch runs out of cash then they borrow cash (at a fee) from another nearby bank. So, solvent banks can tap the reserves of all other solvent banks. It could also offer debt certificates from other banks.

The reason NR couldn’t do this is because the other banks considered that there was a high chance that it was insolvent.

That isn’t surprising though since Scotland’s economy was so closely tied to England’s and England had a central bank.

I think there is no solid argument indicating that fractional reserve banking per se can cause the cycle with extra governmental involvement. The argument put forward by the 100% reservists essentially depends upon the irrationality of bank managers, which I think is unreasonable.

100% reserve banking rest on the premise that what is good for the goose is good for the gander. As every other company maturity matches so should banks. There is no justification for a grant of legal and accounting privilege to work otherwise in politics, ethics, philosophy, economics etc.

Quite untrue . Other companies’ maturity often does not match. There is no law to stop a company borrowing to by a machine on a one year loan, when it actually takes longer for that machine to generate an equal revenue.

J, the cash swapped does not for part of the balance sheet of the banks. It is not a bank asset (loan) going forward under this reform proposal or a deposit (liability), so it cannot be compared to a bank asset as it never seeks to be. It is the cash of the depositors held in custody for them.

The banks no longer have current liabilities (deposits), so they only have capital (shareholders funds and the like) and assets (loans) . This means their net worth has gone up, well to be precise, to the exact tune that the current creditor has gone down by. So to keep the owners of the bank in exactly the same position pre reform as post, this new rise in their net worth can be placed in special purpose vehicles that can pay off the national debt.

When the banks make new loans post the banking reform, there is no reason why these new loans (assets) will not be as profitable as the current ones.

Perhaps you are confusing a deposit which is a liability to the bank, which the banks often pays interest out on, with an asset of the bank, a loan which the banks receives interest on?

The non interest earning assets is the newly printed money. The interest earning assets is the banks loans to businesses etc.
The cash is placed with the banks. The Interest earning assets are transfered to the Mutuals.
The cash does not return the banks to the same net value as it does not replace the value of the banks interest earning assets. The cash does not have the same value to the banks as the interest earning assets, as it not creating a revenue of interest for the banks. That is the flaw in your proposal.

You are really missing something here, the cash given to former depositors in the former depositors and not the banks at all i.e. it never appears in the balance sheet of any bank.

To quote Jesus Huerta de Soto:

“We must point out that Hart suggests the new paper money the central bank prints to back deposits be handed over to banks as a gift. If this occurs, it is obvious that banks’ balance sheets will reflect an enormous surplus, one precisely equal to the sum of demand deposits backed 100 percent by a reserve…
Hart’s proposal that the basis of the reform consist of simply giving banks the sum of the bills they need to reach a 100-percent reserve ratio is a bitter pill to swallow…”

Gifting billions to the banks is a bitter pill to swallow. So here comes the De Soto’s genius with a better PR idea. The billions that the banks will be better off with will be invested in specially created mutual funds.

“We propose that these shares in the new mutual funds to be created with the assets of the banking system be exchanged for the outstanding treasury bonds issued in all countries overwhelmed by a sizable national debt.”

So, you monetise all the bank reserves and force them to hold 100% reserves on demand. As you state, this is non-inflationary as you are injecting the money with one hand but removing it (through the 100% reserve requirement) with the other; but only for one second! After that second has passed, all those bank clients realise they will not get any interest from their savings, and some of them (don’t know or care how many) will move it to the interest-paying money-lending banks. That money gets lent again through the interest-paying money-lending banking system (well separate from the deposit banking system) until it reaches companies and individuals, who use it to buy stuff… and presto, there you have inflation!
The workability of any plan is not only to be determined by its static stability, but by its dynamic one as well.

Post reform I would encourage you to think of an economy with 100 money units (MU) with 50 mu’s in storage accounts and 50 mu’s in timed deposits.

Let us assume the most extreme of circumstances , all 50 mu’s get lent in cash to B. B owned all 50 mu’s in the timed accounts. Now B has 100 mu’s.

Where is the inflation?”

J, with respect, you are failing to see that post reform, B will have 50 MU’s that he had and 50 MU’s that he was lent. The lender DOES NOT HAVE THE 50 MU’s as his cash has moved from one vault that was his to another that is B. IT IS IMPOSSIBLE TO HAVE AN INCREASE IN MONEY SUPPLY! There are never 150 MU’s but always only 100 MU’s that change ownership to facilitate exchange of goods and services produced. This is the function of money after all.

Forgive me for not having read all 400ish comments and therefore perhaps my question has already been answered.

“Mandate all banks to hold your cash (100% reserved) on demand at all times”

How would a bank lend the money to anyone if it had to be in the vault the whole time? And if it could not lend the money how could it be anything other than a storage facility, a slightly safer version of storing your cash under the mattress?

I think you probably mean that the bank could only lend the money to one person at a time, but that is not what you say.

If you run a massive business and someone offers to buy that business for millions or billions, the current method would simply be electronic transfer, right?

Under your system, would it not in fact require fleets of trucks to transport all the physical notes either between people or banks?

As far as personal purchases are concerned, cheques could still allow transfer of funds between, say, you and the shop, but with all the different banks, there would still need to be major cash shipments every week (If not every day) to keep moving the money to where it belongs.

Such a system of constant cash movement would obviously be a very costly thing in itself and also a tempting criminal target, thus shipments would require large guard forces, increasing the expense of financial transactions over and above the base cost of shipping…

You get the idea, right? While in principle it’s a great idea, the actual practicalities of the system make it unworkable. Or have I misunderstood something somewhere?

The requirement is 100% cash backing for a bank as a whole, rather than an individual branch, so presumably the cost of inter-bank transfers could be reduced by having large, secure, centralised multi-bank compounds, so the trucks don’t need to go far, and don’t need to travel on public roads.

What about government spending? Say we buy a dozen new American jets at the usual $90 million or so each. How many container ships worth of money would we have to send to America? How much additional cost would be added by all those container ships? And how unhappy would the Americans (Or anyone else we are dealing with!) be with the idea?

This system seems to forget the main reasons we moved away from carrying cash all the time in the first place: it’s just too unwieldy.

I don’t think we would necessarily see more physical cash changing hands under 100% reserves. People could still exchange electronic IOUs, just as they do today. The difference is that under 100% reserves, it would be guaranteed that each IOU corresponds to physical cash somewhere. Banks would no longer be able to expand the money supply.

That said, I agree that paper notes feel like a bit of a barbarous relic. There’s no reason we couldn’t have a fully electronic honest money system, though e-money generally means giving up some anonymity (dangerous if you become an Enemy of the State).

The literal boatloads of bank notes that would need to be moved between countries – and how little our trading partners would like that.

If all of our money physically exists, that means the only mode of actual exchange between nations is for us to pay them physically, but it also creates a huge problem the other way: how do they pay us?

Let’s say, for example, that Country X wants to buy five billion pounds worth of stuff from us – not a huge amount for some of the bigger industries. The way they would pay us is by electronic transfer of theoretical funds, but that money has no actual physical existence. Under our system, however, no money would exist unless it had a physical presence. So what happens, there?

Do we open the gateway for fraud & money laundering on a massive scale by getting the bank of England to pretty much print money on demand from any company who can prove it has been paid by a foreign company? Or what? What are the mechanisms, here?

Going the other way, we’re talking about moving container ships full of money between nations and making sure the money is securely delivered at the other end (Presumably by a fleet of trucks). That should be great fun in some of the more corrupt and disordered nations… Not to mention, I can’t see too many of our trading partners love it.

Such an approach would doubtless cost our businesses a massive amount of foreign trade, through serious inconvenience value. The only way around that would be to electronically transfer the money and physically destroy the notes at our end – once more opening the door to massive fruad and money laundering possibilities.

Many thanks for taking the time to read this. Your points are covered off in earlier comments.

In summary, the government can promise to print i.e. not actually have to do the job, but just undertake to always fulfil cash demands for converted bank IOU’s i.e. demand deposits. I think if I remember correctly ANON1 suggested this.

When our money was a commodity, it did work exactly as you suggested and staggering as it may be to think now, specie moved from place to place, the net amount that is each day. This served mankind well from the dawn of civilisation to only very recently.

A metallic commodity is the final answer in my opinion. Tried and tested for most of humanities existence, during even rapid period of growth such as the industrial revolution. It is difficult to fraud coined metal, much more so than paper. The paper solution will hopefully set us on the way to solid commodity based money that our government can’t fraud us by and criminals will find it difficult.

Our monetary system is indeed a scam, if we as a sovereign nation had coined exactly what and when we had borrowed over the past 100 yrs, our national debt would be ZERO, hence no Govt borrowing, debt, hence absolutely no need for income tax.

You joke, but of course it’s true that a government could rely entirely on debasement of the currency, rather than explicit taxation.

In a way this would be more honest than our current system, since the public currently assume that government spending is financed by taxation (with a bit of borrowing), whereas it is actually financed by a combination of taxation, borrowing, and debasement.

The best system, of course, would be to have all spending financed by taxation, with borrowing and debasement forbidden. Faced with the true cost, people might think harder before electing a high-spending government.

A wet fish merchant . Did you know Henry Root .He made his pile in wet fish then he sent his ideas to the great & the good and asked for their opinion. He usually enclosed a fiver to encourage them . He then published their replies. You could do the same. And your ideas are better.

Isn’t the fundamental flaw in the plan the massive loss of liquidity it entails?

You say that currently banks are on average 33-times leveraged, which implies that the present demand for credit is 33 times the level of capital deposited in banks. Your proposal, then, will see the availability of credit shrink to at most 1/33 of its current level (and likely much less, since any money in on-demand accounts would not be available). That is a truly stupendous loss of liquidity.

Please can you explain how this will not seriously undermine both the liquidity of current businesses and the ease of starting new businesses? There is probably a perfectly sensible answer to this question, but I must confess that I can’t see how a 100% capital requirement wouldn’t result in a crippling loss of liquidity.

Of course, the other major effect of the proposal, which has already been noted, is that it will greatly increase the cost of banking services for depositors. At present everyone gets to enjoy a comprehensive banking service for free, however little they actually deposit, however poor they are. Under your proposal, however, banking services would become paid services like any other, with poorer people struggling to afford even a basic service, and many therefore reverting to the Personal Mattress Account.

All of these effects seem highly regressive. Choking the supply of credit to entrepreneurs and small businesses and making even basic banking a premium service doesn’t really chime with modern democratic and capitalist ideals. Indeed, it seems to be a reform which would primarily benefit the corporations large enough to be able to dominate the severely tightened credit market, at the expense of anyone else who might want to run a business or open a bank account.

Perhaps you have misunderstood. If you swap one form of cash i.e. the 33 times leveraged demand deposits for cash itself, you have the same level of liquidity, it is just it is now exclusively in cash and not in demand deposits.

Timed deposits are the same size again already today.

A new business will go to the bank like it does today to get some money on loan with people who want to save. There is no difference here. What is different is that bank can no longer from nothing create some credit and open a bank account IOU and deposit credit money. It will need to find a real saver. This by the way is no bad thing. If you think intuitively, a saver is putting away his purchasing power to buy future goods and services. A borrow is borrowing to invest and supply these goods and services.

When a bank can create it out of thin air, there is less incentive to choose a real business plan that will actually work. This creates an adverse selection problem. These businesses that rely on artificial credit creation exist on this alone and are not sustained by real savings. This is the bubble in a boom.

The tax cut doesn’t create new money, it just leaves exiting money in the hands of its rightful owners (wealth would no longer be confiscated to be transferred in interest payments to government creditors).

It’s possible that Joe Taxpayer would be more likely to spend his money than Joe Bondholder, and it’s possible they have different preferences (perhaps Joe Taxpayer likes beer, while Joe Bondholder likes wine), so (some) prices might rise in the short term, but this strikes me as fundamentally different from the long-term, limitless inflation caused by expansion of the money supply.

That’s right. Any difference would be caused by the shift in distribution of wealth changing the saleability of consumption vs investment goods. This causes “inflation” only if price inflation is only measured on the consumer goods side.

If I did this reform (and I wouldn’t do this reform because I think it’s a bad idea for other reasons) then I’d try to make a more neutral tax cut, such as cutting corporation tax.

If you had a fixed money supply, which this proposal is all about, you will have more disposable income and the government less, as it would have extracted less from you.
Money supply still stays the same, it is just a question of who has it.

This wont work because there will be little to no incentive to bank anymore. Why would a bank accept money from someone if they cannot benefit from that act?

Under your system, you would have to force banks to accept deposits, placing a responsibility on their shoulders (and thus a cost). Indeed, this responsibility would increase in relative terms, as bank robberies and the like would become vastly more attractive as a greater portion of the money supply was in raw cash.

Moreover, banks could no longer offer interest of any sort on pure deposits – the only reason we receive interest on deposits now is because the bank is making money off of them, and thus has an incentive to maximize the number of deposits it takes in.

The first part of your proposal would result in one of two outcomes:

1. Banking ends as we know it. I have no idea what would occur as people lost the ability to deposit their savings with banks. This is not, I think, the most likely outcome.

2. Banks would provide no incentive to deposit “pure” deposits, and would pressure their depositors heavily to instead loan them the savings, recreating the same system in place today under a different, perhaps less deceptive, name.

Step 6 of your plan is also flawed. What, precisely, does it mean that Britain is $850bn in debt? It means that it has spent $850bn worth of money that it has not yet produced. Your proposal would pay this off, technically, but would do so in a way that is precisely as inflationary as printing $850bn worth in pounds sterling and paying it off now, with none of the other changes you propose.

The fact is, your _economy_ is in debt. People have injected $850bn _into_ your economy that they have not yet got out of it. This cannot be “fixed” – the only non-inflationary way out of this is for your economy to produce $850bn in surplus over time and get that money to those who loaned you money before.

It seems likely that people would pay the banks to hold their deposits. In many countries, banks already charge a monthly fee for current accounts. People are willing to pay for the convenience and security.

You’re right that bank customers seeking interest would need to switch to explicitly loaning money to the bank. This wouldn’t be the same as the current situation, because it would no longer be possible for multiple parties hold simultaneous claims on the same money. Also, because customers would be making explicit investments, and accepting a certain amount of risk, there would be no justification for government guarantees.

Why would a bank not want to bank anymore? It makes money from matching saver to borrower for a start. It can change for safe keeping . It may choose not to charge for safe keeping to get the money it to earn a turn by lending it out to a worthy borrower. This is how it was for most of our history.

I desire by this reform to end banking as we know it.

The former depositors can do all of the above which is the essence of banking. Why not?

Step 6 you have demonstrated that you have not understood. To recap, convert demand deposits into cash. This is a swap of one type of money for another type, this is not inflationary. Where the bank did have a liability to a depositor it no longer has that liability. This means its net worth has gone up to the exact tune that its liabilities have gone down by. The excess assets created by this, the loans to companies like mine, can then over the coming years pay down the debt. The former depositors are in a better position as they actually have cash, the bank shareholders still sit in banks with exactly the same net worth post the reform. The taxpayer is relieved of the burden of paying off the national debt. The debtors to banks , such as the companies that formally owned them money, now pay the money back to bondholders. QED no inflation + debt paid off.

Friedman supported this kind of proposal. He wrote as recently as 1992 on it and as early as 1948. His inspiration were his teachers, Mints, Knight, Simmons who in turn we followers of Fisher. Anyway, each had something useful to say on the matter.

The authority and privileges the Bank of England are sustained by our government. In the same way that the government can pressure the BBC by threatening to do away with licence fees, the government can pressure the Bank of England by threatening to remove its monopoly rights to print money.

If such pressure does not suffice, the government can follow through with its threats, and seize money-printing privileges from the Bank of England.

Of course, like any government (democracy or dictatorship) the actions taken by the state can be constrained by an angry citizenry. It would be important for the public to buy into the proposal (or at least be indifferent to it).

The State can print – why not leave it at that as it has the monopoly of legal tender. What department does it is neither here nor there.

Credit is a different form of money to cash. Cash is physical and credit is created out of thin air by the banking system and the central bank. This exists in what you see in your bank statement. If we all went in and claimed what was in our bank statements in cash, only 3% of cash would be forthcoming, the rest would not be there. The bank would have to say come back in 25 years on a monthly basis and as the chap I lent it to pays off his mortgage, you will get paid your money back or some such other delaying tactic.

The Bank of England created £200 bn of IOU’s out of thin air and bought £200 bn of the outstanding gilts. Thus we pay £10 bn of interest on this debt when at a click of a button, it could be deleted. I do not know what portion of this if any was used to bail out the banks. Your sentiment if directed to the £200 bn is certainly right. It could be deleted today; you, I and all taxpayers would be £10 bn better off via having fewer extractions taken from us.

If it was to be done it would have to be done on a global (or at least currency wide) basis so we couldn’t do it ourselves.

It’s not inflationary because while they are printing money they are at the same time reducing the multiplier to 1 – so all the money in circulation in the system becomes “real”.

The big problems are that :

It tends to be deflationary whereas fractional reserve banking tends to be inflationary – moderate deflation is more difficult to manage than moderate inflation (some input costs like wages tend to be sticky so the knock on impact is multiplied).

It is inefficient – if someone has to lodge a dollar in order for that dollar to be loaned then you have to match dollar for dollar lenders and lodgers with the same timeline or you end up with mismatching.

It transfers the cost onto the consumer – the banks will end up charging people to hold their money for them on demand as the bank can only make a margin off term deposits so current accounts will cost a lot more.

The knock on impact of that fact is the likely move out of banks to home storage of short term demand money requirements. That move away from electronic money is costly, inefficient and socially dangerous (people break into your house more frequently if they think you have your months “float” under the bed)

I would like to refer you to the comments made by Elliot Kane in comment number 424 and my response 425 re the international dimension and I invite your further thoughts.
There can be no deflation in money as it all exists in physical form. This has been said in much comment on this site.

There can be price deflation as all of us entrepreneurs continue to try to offer goods and services cheaper and better than the next competitor. We invest in more intense capitalistic methods of production . More production means more goods offered with the same money in society chasing it. Purchasing power of money goes up and prices go down. Think of what has happened with cars and in recent times with computers.

I accept, with three or four generations (out of the whole history of mankind) now used to price inflation as opposed to moderate price deflation, they may take a while to get used to this i.e. your money lasting longer each year over the prior year. Historically only things like massive gold reserve discoveries have disturbed this trend.

As mentioned before in other comments, like Tesco sells cans of baked beans a £0.07 per tin, well under cost, to get you through the doors to spend your money, banks may well still offer free current accounts. They may not though and a charge would be levied for a legitimate service of security offered.

I trust this helps to clarify matters, please get back to me if it does not.

The government can print £850bn, and if it were to do so it could either pay off the national debt or give it to the banks in exchange for their assets (mortgages etc)

The government can also legislate to regulate high street banking, including by increasing the reserve ratio to 100%.

This is why the plan is stupid:
1. There WOULD be inflation in the same way as if the government simply printed money and either paid the debt or gave it to the banks. In your plan the money supply would increase because bank customers would suddenly find they aren’t being paid any interest and that they’re being charged for their bank accounts, they would then start lending to banks on your inflexible terms and this would increase the money supply. Therefore the plan doesn’t have inherent advantages over other policy in this respect.
2. While the government have control of monetary policy there is no risk of a run on any bank. The government could put in a guarantee that they would print money in the event of a bank run so as to meet customer’s deposits. With this in place there would be no fear and no bank run anyway, so there is really no need to take action in advance of a run.

Seeing as this plan of yours does not help with bank runs, pay off the debt or recapitalise the banks any better than traditional separable economic strategies which as individual strategies are undesirable I see no reason why it is a logical strategy to put into action.

It’s not so much that the idea is flawed, just that it’s not really any better than many of the other ideas out there

You have not understood what I have suggested here, that is clearly demonstrated by your statements.

These points have also been covered off in the comments, but with 425, I do accept that it can be difficult to read them all!

You suggest that inflation would be caused as the cash now in the hands of the former depositors will move to borrowers’ right?

Think about this, a former depositor A, gives the bank permission to take his cash £X and lend it to B , i.e. to forgo his purchasing power over that £X to the favour of the borrower B who can now use the purchasing power that was formally A’s. There is no new money here to create inflation, just a move from A to B. B will have to work hard to provide a return to A (interest and capital) to make the whole thing worthwhile. Certain asset classes i.e. good businesses may get more capital offered to them (at bloody last) and poor ones that were formally backed by loose money and are predicated on bubble activity will get less (too right as well). So there may be asset class adjustments but as the amount of money never changes, there can’t be a price inflation.

Under 100% reserve banking, you cannot have a bank run, so you are mistaken on this point as well. We would not have a software run if Apple went bust or any other 100% reserved company i.e. anything but a bank. A 100% reserve bank can go bust because it is incompetent just like any other company, but that is it. This will not cause a system wide run. All people could run into their banks and demand to see their paper cash and unless fraud etc, it will be there. As you know, under a fractional system like we have today, it is not there in a run situation.

“a former depositor A, gives the bank permission to take his cash £X and lend it to B , i.e. to forgo his purchasing power over that £X to the favour of the borrower B who can now use the purchasing power that was formally A’s. There is no new money here to create inflation, just a move from A to B”

I think that in practical terms you are wrong. Borrower A, in the knowledge/belief that their money will be returned to them will act as a consumer as if they had their money to hand (almost). Even if a consumer has their savings tied for a year or even ten years, they are likely to consume more of their current income, consumer more of their liquid savings etc, than they would have done if their bond was not in existence. This is where the money supply increases. This isn’t obvious on a macro level but it is on a micro level. I for one have almost all my savings in fixed-term bonds because in summer 2008 I predicted a long period of low interest rates and so tied up my money for years at 6% or so, a few years on I am acting as though that money were cash I could call upon, am not saving much of my current income, and would be happy to borrow against it. This is rational behaviour, and would be observed in your model

As for the bank run part, I am not challenging the fact that a bank run is problematic for the wider economy, pretty devastating in fact, however what I am debating is the point that your 100% reserve idea is any more secure than a system in which the government simply promise to print money to avert any run. In economic terms I can’t see a difference between the two.

You are one of our wiser observers to get your money locked away, I hope in good corporate bonds.

You can’t spend it. It is owned or leased of you like by someone other than you. They have spent it. There is no increase in the money supply here.

You are confident in the maturity of the coupon on your bond, this makes you happy, this makes you spend more of our current income than you may save if not comforted by your bonds. Still no increase in the money supply here.

Your demand to hold less money i.e. to use its services to exchange for goods and services means that those favoured goods and services are embellished by your purchasing power. This must be at the expense of those that are not. Where is the money supply increase?

The difference between a bank run with demand deposits is that demand deposits are bank IOU’s created out of thin air. Only 3% of cash sits in the vault. 3% of people will get their purchasing power, 97% will not. With 100% reserved cash banks, 100% will get their cash back and no one will not. This is a very big difference.

Another slight problem with the logic of this piece, is the idea that bank deposits backed up with Bank of England notes are any more “sound” than those that aren’t.

When you say “it now really exists in cash”, that’s just the problem, it exists in “cash”, that funny white piece of paper which we all carry around with us and pretend is actually something real. “Cash” is of value to us because of a historically established custom that it will be convertible into goods, and this trust we have in the value of our paper money is note very dissimilar to the trust we have in our banks that they will convert out accounts into paper money.

If there is a threat of a run on banks it is a loss of confidence in this convertibility, and it is possible that one could occur on sterling too. When there is a run on the bank it is due to a rush to convert deposits into cash, causing the small amount of cash available in a bank at the time to run out, ending convertibility. An equivalent “run on cash” would occur when everyone rushed to the shops to convert their cash into goods all at the same time, causing the shops to run out of goods and the convertibility to end, making cash worthless.

A bank account backed up with carrots would be a lot more “sound”.

“Runs on cash” are a common feature in countries experiencing hyperinflation. There is a common belief that cash will be worthless and in the ensuing panic, cash becomes worthless.

To Christian
Thank you for your comments.
Cash is stage one. In 1,200 words for a lay audience, I could then not spell out the move to commodity money. Carrots you say in jest, the market I suspect would choose gold or silver or a mix of both.
I certainly would want to end up with commodity money, free of government control.

I do believe there is a flaw in this plan. It is an odd one, not immediately seen on the face of it, but very much a problem.

Primarily, you appear to be basing your position on the mistaken premise of “out of thin air” which is patently not true. FRB is an interlinking set of dominoes, a chain of lending obligations, not “out of thin air”. I know it can be used to “explain” FRB to others, but I think it is not explaining, but misleading[1].

You next suggest that current business lending assets held by banks are to be moved to a mutual and all deposits converted to cash. You must move ALL lending out of banks, not just business lending, otherwise what @Tyler May 23rd, 2010 at 23:04 says could occur [2].

If you move those loans out to a Mutual, how can you “immediately” pay off the National Debt? That would presume the Mutuals SOLD those loans on and used the receipts to erase the National Debt[3]. But that is a side issue to the plan and I think we could see the debt being “rapidly” paid off as those loans mature. Again, this is not a deal breaker, but useful to point out.

While the Mutual does not appear to increase the money supply, for it just diverts money that comes from one section of the economy to pay off another, this arrangement does not, in fact, have the same consequences due to what I believe is a fundamental misunderstanding of the Fractional Reserve system as it operates over time.

When loans are paid off currently, the money is either

a) returned to a “depositor” if they decide to, contemporaneously, withdraw cash
OR
b) used to replenish reserves if a) had already happened
OR
c) the bank on-lends the amount again.

In terms of money supply, your proposal is not the same.

When repayments are made in your proposal, the money

a) goes to the mutual
b) Is used by the Mutual to pay off National Debt
c) Those repayments are then BANKED by the erstwhile holder of that debt

Back at the bank with its depositors, the proceeds from the repayment of the Gilts will be banked. In the past, the repayments were to the loans and if a depositor withdrew any money, then on-lending would have to be curtailed by the amount of the depositor withdrawal. But not now.

If a depositor withdraws £100 to buy something eventually from a company that had borrowed money, the £100 leaves the bank, is moved to the company account, used to repay the loan lodged at the Mutual, is on-passed to the Gilt holder and is then re-banked.

Now, this seems to be ok, but what used to happen is that when the depositor withdrew the money to buy from the company and the company paid off its loan? I will tell you – that £100 disappeared. Completely. Gone. Finished. Ended. THAT is the only “thin air” that exists around here. It was NOT on-lent or available to the economy because the Bank had to replenish its reserves to the point at which it was just before the depositor took out their cash to spend and so enable the repayment of the loan.

I will say that again: because the Bank had to replenish its reserves to the point at which it was just before the depositor took out their cash to spend.

It is thus not available to the economy. It is dead, in a vault.

In your proposal, the depositor spends, the company pays off, the money goes to the mutual to buy back the Gilt and the ex Gilt owner banks the cash and it still exists to be spent at will. All of it.

THAT is how your proposal inflates the money supply.

I claim my £1000.

[1] I do wonder if much of the energy towards 100% reserve is based upon just the mistaken premise of “out of thin air” and the outrage it would generate, and in fact generated in me until I worked out how FRB operates.

[2] If all loan assets are converted to cash, I want to set up a bank just before you switch over, please. I will open a string of accounts, lend myself money, deposit it back, lend it out, deposit it back until I can do so no more, then you convert all the deposits to cash and then I use that to pay the (i.e. my) bank back, shut up shop and retire.

[3] Fact is, who is going to buy all those loans, or are you planning to create an SIV to sell them or the mutual that contains them? Do you think a ratings agency would be needed and some insurance in case of default? In a way I am joking, but I am also serious. One could say that the interest payments should balance out the loans that are defaulted on, also.

Most acts of human entrepreneurship are created ex novo or you could say out of thin air. The thin air of the thinking acting mind. I do not have a problem with creating things out of thin air.

A bank IOU is out of thin air on the whole. I do have a problem with this as the other party in the transaction, the depositor, does not understand this at all. This makes it a legitimate point to talk about. Also, for a bank to exist, it requires a grant of privilege in law and in accounting standards to be able to exist i.e. what is good for the goose is NOT good for the gander. A level playing field in the rule of law of vital for a just and liberty loving society.

You say I suggest this “You next suggest that current business lending assets held by banks are to be moved to a mutual and all deposits converted to cash. You must move ALL lending out of banks, not just business lending, otherwise what @Tyler May 23rd, 2010 at 23:04 says could occur [2].”

I do not, as over 50% of all lending is timed and is not part of the plan. The only part covered by this act of reform is the demand deposit side of things.

If Mutuals take the liability to pay off the National debt, as far as the government is concerned it no longer has the liability as it has paid it be doing the reform, now the Mutuals then pay down the debt as their loan repayments from business come in. I accept that the language around this to be tidied up and made clearer.

I am sorry Tim, you do not understand FRB at all. You say,
“When loans are paid off currently, the money is either
a) returned to a “depositor” if they decide to, contemporaneously, withdraw cash
OR
b) used to replenish reserves if a) had already happened
OR
c) the bank on-lends the amount again.”

If a) happens, it does not go back to the depositor as the loan originated from the bank itself and was created ex novo or ex nihilo , out of thin air. So when repaid back it goes back from whence it came, to thin air, unless c) happens.

Consider A deposits at the bank B £100, B lends Entrepreneur C £100 who deposits at bank B. There are now £200 units of money when there was only £100 to start off with. When Entrepreneur pays back his loan i.e. the £100 to Bank B, then money supply is then £100 again, unless the bank creates it out of nothing again and re lends.
The problem today is there is more paying back and less lending i.e. a “credit crunch.”

Reserves are its equity capital and retained profits not loans or deposits.

You conclude “In your proposal, the depositor spends, the company pays off, the money goes to the mutual to buy back the Gilt and the ex Gilt owner banks the cash and it still exists to be spent at will. All of it.

THAT is how your proposal inflates the money supply.”If the money supply was £100 demand deposits that post reform become £100 cash and £100 timed deposits, money supply is £200.

If £100 is owed to gilt holders by the mutuals, the companies work hard to sell the former deposit holders goods and services that they want, so the cash of £100 goes down to £90 (as goods are produced and sold) and the £10 moves to the company and they make a profit of £1 and use £9 to pay to the gilt holder who then deposits for storage £9 back in the bank safe as the does the company with its £1 profit. No where does the money supply grow or shrink.

I think I will stop here commenting as you demonstrate a basic error in understanding the banking system that is covered off in this way in all A level text books and is uncontroversial in economics.

I hope this is helpful , but I do suggest some foundational reading at this point.

3. My initial impression having skimmed thru your article is that you unnecessarily confuse two issues: 100% reserve banking and paying off the national debt (which I agree is easily done). I shall go thru your article (and the comments) with a toothcomb with a view to claiming the £1,000!

One of the key concepts neglected by Keynes, the Monetarists and, now I have looked at the article you suggest, Lerner is the structure of capital. I recommend “The Importance of Capital Theory” by Robert P. Murphy:

Once we understand how our present problems are due to a Fed-induced distortion in the capital structure, it becomes clear that the worst recommendation is for the Fed to cut interest rates and pump in ever more “liquidity.” It was artificially cheap credit that fueled the housing boom in the first place. Greenspan brought the federal funds target rate down to a ridiculous 1 percent — meaning the interest rate was actually negative, once we adjust for price inflation — and held it there for a year. He did this in order to (apparently) obviate the need for a harsh recession in the “real economy” after the dot-com crash. But in fact he sowed the seeds for our present crisis. If Bernanke continues shoveling in hundreds of billions to needy bankers, five years from now Americans (and the rest of the world) may look back fondly on the present the way the 2001 downturn now seems like a minor inconvenience.

1. Having read thru the above material, I see nothing that necessarily connects full reserve banking with printing money to pay off the national debt: they are SEPARATE issues.

2. No one seems to have mentioned what I think is the main merit of full reserve banking, which is that it helps avoid the economic cycle exacerbating characteristics (i.e. the “pro-cyclical” characteristics) of the existing system. That is, the existing commercial bank system creates money exactly when it shouldn’t: in the lead up to a boom and bust. It then destroys money (via deleveraging) in a recession.

4. Ellie Valinska is quite right when she says above “I have problem with printing money and pretending you didn’t…”

“J” (in claiming the £1,000 on 12th June) points to the same flaw in Baxendale’s proposal (using very different words). He says essentially that replacing interest earning government debt (gilts) with non interest earning debt (cash) cannot be done on a £ or £ basis. Ellie and J are both right (but Baxendale is not 100% wrong). The solution to this (Ellie + J) versus Baxendale argument is thus.

There is not a HUGE difference between Gilts (Treasuries in the U.S.) and cash. That is, arguably gilts are just large denomination bank notes that pay interest. However giving all gilt holders cash for their gilts (i.e. quantitative easing) would I assume be mildly stimulatory or reflationary (certainly QE was supposed to be stimulatory).

But this stimulatory and/or inflationary effect is not a problem: just mix the latter method of paying off the debt with a DEFLATIONARY method, that is getting the money for debt repayment from raising taxes and/or cutting government spending. The above two “levers” provide a means to effect any speed of debt reduction desired and any stance on the reflation – deflation scale while doing so. For example, for a faster rate of debt reduction, apply more of both levers. Or for a more deflationary stance, apply more of the deflationary lever relative to the inflationary one.

My one quibble with your proposal is that it does not distinguish between paper money, which is legal tender and must be accepted only in payment of a debt, and hard currency, which is legal tender for all transactions.

Here in Canada we have numerous deposits of gold and silver, many of which are not mined at present due to the high royalties demanded and the red tape involved in opening a new mine. In addition to a final printing of war-time paper and an end to fractional reserve banking, we will need hard currency, and deposits made in hard currency which are not a debt and can therefore be demanded in the same coin. Only a dual paper/hard currency system can help to ease the trauma of deflation, which is I believe a necessity but best done in a controlled and gradual manner.

I will be arguing for silver, as it is our traditional money and likely to become increasingly valuable. As it happens, Canada has a coin which is both a dollar (semi-decimal) and a shilling. The Canadian dollar is 288 grains of fine silver, in a coin of .800 fineness which has prevented most of them from being melted down as scrap.

We’ll need a gold coin too, and my favourite is the sovereign, which should be a currency in its own right and not tied to anything else except on open exchanges. To pretend it is a pound of sterling is fraud, even when it is more valuable not less. We’ve seen quite enough of that, haven’t we?